London, 29 March 2010

Bassam Fattouh of the respected Oxford Institute for Energy Studies (OIES), a leading academic researcher on oil markets, has published a landmark assessment of the influence of fundamentals and speculation on the formation of oil prices over the past decade.

If his view is accepted by policymakers, it could break the stalemate about whether fundamentals or speculation drives commodity markets, lead to a more constructive discussion about how to regulate futures markets, and improve cooperation between producer and consumer countries.

Fattouh's findings are set out in a powerful paper on "Oil Market Dynamics through the Lens of the 2002-2009 Price Cycle," prepared for ministers from producer and consumer countries meeting in Cancun next week as part of the International Energy Forum (IEF)  see www.oxfordenergy.org/pdfs/WPM39.pdf

Dual Nature of Crude Oil

The fundamentals-versus-speculation debate long ago degenerated into a dialogue of the deaf. Fattouh notes "One view attributes the recent behaviour in oil prices to structural transformations in the fundamentals of the oil market.

An alternative view considers that changes in fundamentals, or even expectations, have not been sufficiently dramatic to justify the extreme cycles in oil prices over the last two years and that oil markets have been distorted by substantial and volatile speculative financial flows."

So the paper attempts to move the debate on by developing a unifying theory incorporating elements of both and using it to explain recent market oscillations. It sets out in convincing detail an "inclusive" framework emphasizing the dual nature of crude as a physical commodity and a financial asset: "As a physical commodity, the price of oil is influenced by current market fundamentals, such as the supply-demand balance, the level of inventories and the availability of spare capacity. As a financial asset, the price of oil is influenced by expectations of market fundamentals, as well as other macroeconomic news that influences those expectations".

Destabilised Expectations

Fattouh concludes that both fundamentals and speculation played a role in the massive market movements experienced in recent years.

Especially in the first half of 2008, when prices turned parabolic, the apparent weakening of normal feedback mechanisms that would in the past have boosted supply and restrained demand, despite surging prices, destabilized expectations among both investors and physical market players.

Some common beliefs that helped stabilise prices in a relatively narrow range throughout the 1990s broke down: (1) Traders and investors were no longer convinced high prices would temper demand; (2) High prices did not seem to bring forth increases in non-OPEC supply; and (3) OPEC appeared unable or unwilling to prevent oil prices rising dramatically by increasing its own output.

The apparent lack of feedback caused a dramatic widening of the implicit trading band to the upside, as the consensus about the range of long-term feasible prices broke down.

A Keyynesian Beauty Contest

Heightened uncertainty about long-term pricing encouraged "herding behaviour," as a wide range of market participants came to focus on just a few variables and pronouncements of a few influential policymakers and commentators, in the hope of winning (or at least not losing) a Keynesian beauty contest.

"Until the collapse of the oil price toward the end of 2008, market participants based their decisions on a few signals and public information, such as news about inventories and the weak dollar, while ignoring other types of information such as weakening U.S. and OECD oil demand and the fact the market was well supplied."

Financial players were not shy about exploring and testing the upper and lower bounds of the newly widened trading bands.

Collapse and Rebound

The market began to snap back when Saudi Arabia announced output increases at the Jeddah summit in June 2008, followed by market confirmation the extra oil was flowing.

It rendered untenable the previous expectation that OPEC could not or would not raise production in response to higher prices. At the same time the market began to take belated notice of "mounting evidence in the rear-view mirror that OECD oil demand had weakened far more than initial expectations and provisional data suggested."

Fattouh notes that the correction's first leg, the $40 drop from the market's peak around $145 back towards $100, occurred in July and August 2008, before the implosion of Lehman in September 2008 plunged the economy into a tailspin and triggered a liquidity crisis affecting all markets. The market was already correcting before the recession took hold.

The subsequent price stabilization and recovery in 2009, especially at the front end, despite weak demand and high inventories, is attributed to OPEC's credible supply response and the impact of "analysis and commentary by influential players" on expectations about shortfalls in long-term supply.

"Based on such analysis, expectations that the future supply- demand balances will tighten in the medium to the long-term have become dominant ... Concerns about long-term fundamentals placed a limit on how much market players were willing to discount the price at the front end."

Anchors are Important

By giving expectations a central role, Fattouh emphasizes the factors which help stabilise or "anchor" them. He argues the vertiginous price rise in 2007-2008 occurred when the feedback loops that previously anchored the market came unstuck. Other examples are the Saudi output increase at Jeddah; King Abdullah's repeated statements that $75 represents a "fair" price for both consumers and producers; and pronouncements by prominent analysts and commentators.

Fattouh notes price stability is regarded as desirable by policymakers. In contrast "Sharp swings are undesirable since they increase uncertainty, hamper global economic growth and undermine investment in both the oil and alternative energy sectors." The importance of expectations gives policymakers a means to reduce excessive volatility, albeit in a limited way, by creating or enhancing anchors.

Fattouh argues the "recent relative convergence of views by key players about a preferred price range ... has helped stabilise expectations and create a focal point for the oil market". It may have helped consolidate price movements within an implicit $60-80 band in the last nine months.

Reinforcing this anchor could help return the market to a more stable trading pattern, but only if the chosen range is sufficiently in line with fundamentals to be credible. It may require what Fattouh terms "confidence building measures" and increased signs of producer-consumer cooperation to work.

Moving the Debate Forward

In 2008, the Commodity Futures Trading Commission's own taskforce on commodity markets concluded "current oil prices and the increase in oil prices between January 2003 and June 2008 are largely due to fundamental supply and demand factors." Preliminary analysis "does not support" the argument speculative activity has "systematically driven" price changes.

Other regulators, such as the UK Financial Services Authority, have echoed this conclusion about the absence of credible evidence for speculation having any impact on prices. Fattouh does not present econometric estimates for the impact of speculative factors (and argues convincingly it is not possible to analyse them in isolation). But proponents of the "no evidence" argument have not given detailed numbers either to explain how limited changes in fundamentals could have produced such a dramatic variation in prices over a short space of time.

Fattouh is a widely published and respected author on oil pricing. His paper is significant because it lends powerful intellectual support to the argument that speculation could have played a part in recent movements, and provides a convincing explanation, with impressive support from a range of academic and industry sources.

It provides a much more sensible approach to thinking about price movements and has the great merit that it is written in a language policymakers can comprehend. It should be required reading for regulators, banks, and ministers in both producing and consuming countries as they grapple with questions about regulation and security of supply and demand.

Ends --

By John Kemp, Reuters columnist - for Commodities Now

The views expressed are his own.